In June, 1998, the Financial Accounting Standards Board (“FASB”) issued a new standard entitled Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (“FAS 133”) that must be implemented for calendar-year business entities effective Jan. 1, 2001. FAS 133 requires that all derivative financial instruments, with only a few defined exceptions, be booked and adjusted to fair value at least quarterly. This is a huge departure from earlier standards and accounting traditions. Financial instruments or contracts, known as derivatives, except in a few defined exceptions, were accounted for at historical cost, and this cost was amortized. Hence, there is now a distinction between derivative financial instruments (e.g., at fair value) versus financial instruments (e.g., at amortized cost).
Complications arise in particular when a derivative financial instrument, the hedge, is used to hedge a financial instrument, the hedged item. If the derivative financial instrument does not meet the FAS 133 requirements for special hedge accounting of cash flow, fair value, or foreign exchange hedges, any changes in fair value are reported in earnings. Special hedge accounting, thus, is a privilege, not a right. Qualifying criteria includes, for example: (a) identifying the hedged item; (b) identifying and designating the hedging instrument; (c) identifying the type of hedge; (d) planning and documenting the hedge strategy; and (e) measuring effectiveness at least quarterly. It is important to understand that the FASB has not defined an effectiveness test to measure the effectiveness of the hedge to be used by business entities to qualify under special hedge accounting.
As a result of FAS 133, many business entities' current accounting methodologies are not permitted without serious reporting implications. For example, currently, under synthetic instrument accounting which some business entities utilize, interest rate swaps are “off balance sheet.” Swaps are the most common form of hedging interest rate risk using financial instruments derivatives. A swap is basically an agreement in which two parties exchange payments over a period of time. The purpose is normally to transform debt payments from one interest rate base to another, for example, from fixed to floating or from one currency to another.
More specifically, an interest rate swap is a contractual agreement entered into between two parties under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. The principal amount is notional because there is no need to exchange actual amounts of principal in a single currency transaction because there is no foreign exchange component to be taken into account. Equally, however, a notional amount of principal is required in order to compute the actual cash amounts that will be periodically exchanged.
Under the most common form of interest rate swap, a series of payments calculated by applying a fixed rate of interest to a notional principal amount is exchanged for a stream of payments similarly calculated but using a floating rate of interest. In other words, one party pays a fixed rate calculated at the time of trade as a spread to a particular Treasury bond, and the other side pays a floating rate that resets periodically throughout the life of the deal against a designated index.
As a result of these types of interest rate swaps currently being “off balance sheet,” as explained above, an entity will book the net gain (or loss) from the swaps to its income statement as a reduction (or addition) to net interest expense but do not book the mark-to-market(“MTM”) value of the swap during the life of the swap and do not adjust the book value of the hedged bond during the life of the swap. Additionally, under these circumstances prior to FAS 133, if a swap were terminated prior to maturity, any termination settlement (MTM gain or loss) would be booked as an adjustment to the bond's book value and amortized over the remaining life of the bond. Again, however, due to FAS 133 this methodology is no longer permitted.
Business entities that seek to qualify for special hedge accounting by categorizing swaps as “fair value hedges” under FAS 133 must satisfy two primary requirements.
The first primary requirement is that the swap be “highly effective.” If the effectiveness of the hedge is less than 80% or more than 125% of the matched risk, the hedge fails the effectiveness test and none of the swap MTM volatility can be offset. The highly effective test must be successfully satisfied throughout the life of the swap and not just at inception. If a particular methodology results in a number of swaps failing the test during the life of the swap, accountants may question whether this methodology should be allowed with any swaps.
The second primary requirement concerns how closely the swap MTM correlates or matches with the bond's MTM, assuming the swap qualifies as highly effective. To the extent they do not offset (“ineffectiveness”), the differential flows through the income statement and creates earnings volatility.
Since the FASB has not defined a test to measure the effectiveness of the hedge, there is a need for a methodology doing so. The present invention provides an effectiveness test methodology to qualify under special hedge accounting by creating a methodology for mismatched maturity hedging, called compensatory ratio hedging, that is sufficiently dynamic to accommodate the differences in swap and bond valuation drivers.